Explaining the accrual anomaly by market expectations of future returns and earnings

This study examines the accrual anomaly under the framework of the Campbell [Campbell, J.Y. (1991). A variance decomposition for stock returns. Economic Journal 101 (405), 157-179.] model. The Campbell (1991) model shows that realized asset returns are a joint function of 1) expected returns, 2) revisions in market expected future returns (i.e., return news), and 3) revisions in market expected future cash flows (i.e., cash flow news). The current study adopts the Easton [Easton, P. (2004). PE ratios, PEG ratios, and estimating the implied expected rate of return on equity capital. The Accounting Review 79 (1), 73-96.] model to estimate proxies for expected returns, return news, and cash flow news. The results show that firms with low accruals have lower expected returns than firms with high accruals, which is contradictory to prior research that argues that firms with low accruals are more risky. However, investors underestimate (overestimate) future earnings growth, a proxy for cash flow growth, for low (high) accrual firms. Further analysis demonstrates that earnings news (proxy for cash flow news) plays a major role in explaining abnormal returns associated with the accrual anomaly.     

Accruals,Investment, and Future Performance

It is well documented that accounting measures of investment, such as working capital and capital expenditures, negatively predict future stock returns. The earnings fixation hypothesis suggests that investors overestimate and overvalue the persistence of the accrual component of earnings. Another stream of the literature argues that since accruals capture growth, the accruals anomaly can be explained by the investment anomaly, which finds that firms that grow their assets tend to have lower future returns. As empirical proxies for accruals and investment are either positively correlated or interchangeably used, it is difficult to distinguish between the competing hypotheses in empirical tests. This study contributes to the debate by identifying two special economic settings in which the two explanations offer diverging predictions. First, investment in research and development (R&D) represents an investment expenditure that reduces earnings but is not subject to accrual accounting. Thus, the earnings fixation hypothesis predicts a positive relation between increases in R&D investments and future returns, whereas the investment anomaly predicts a negative relation. Second, firms operating with negative working capital have working capital accruals that are negatively correlated with other forms of investment and growth. Therefore, while the earnings fixation hypothesis still predicts a negative relation between accruals and future returns in this setting, the investment explanation predicts a positive relation. For both sets of tests, the empirical evidence supports the earnings fixation hypothesis for the accruals anomaly and is inconsistent with the notion that the investment anomaly subsumes earnings fixation in explaining future stock returns.     

Earnings Persistence and Stock Market Reactions to the Different Information in Book-Tax Differences: Evidence from China

Prior studies document that book-tax differences (BTDs) reflect divergent reporting rules for book and tax purposes, and contain information about earnings management and tax planning. In this paper, we investigate whether the regulatory and opportunistic information impounded in BTDs differentially influences earnings persistence and the earnings–returns relation. Using BTD data from China, we separate BTDs into normal BTDs (NBTDs) and abnormal BTDs (ABTDs). NBTDs are more likely driven by regulatory differences between accounting and tax rules and ABTDs are more likely driven by earnings and tax management activities. We find that firms with large positive and negative ABTDs (NBTDs) exhibit less earnings persistence compared to firms with small ABTDs (NBTDs). However, the level of earnings persistence for large unsigned ABTD firms is significantly lower than it is for large unsigned NBTD firms. While large unsigned NBTDs appear to enhance the earnings–returns relation, we find no evidence that large unsigned ABTDs affect the earnings–returns relation. Overall, the results suggest that the differing components of BTDs have differential implications for earnings quality. Additional tests show that ABTDs and NBTDs can provide incremental information about earnings persistence beyond the information in discretionary accruals and total accruals, suggesting that the investigation of BTDs adds value to financial analysis.     

The predictive power of investment and accruals

We test whether investment explains the accrual anomaly by splitting total accruals into investment-related and “nontransaction” accruals, items such as depreciation and asset write-downs that do not represent new investment expenditures. The two types of accruals have very different predictive power for firm performance, not just for future earnings but also for future cash flow and stock returns. Most importantly, nontransaction accruals have the strongest negative predictive slopes for earnings and stock returns, contrary to the predictions of the investment hypothesis. A long-short portfolio based on nontransaction accruals has a significant average return of 0.71 % monthly from 1972 to 2010 and remains profitable at the end of the sample when returns on other accrual strategies decline. Our results suggest that nontransaction accruals are the least reliable component of accruals and show that a significant portion of the accrual anomaly cannot be explained by investment.     

The pricing of conservative accounting and the measurement of conservatism at the firm-year level

This paper analyzes the relation between equity prices and conditional conservatism and introduces a new measure of conservatism at the firm-year level. We show that the asymmetric properties of conservative accounting, the existence of non-accounting sources of information, and the properties of GAAP related to special items combine to generate a nonlinear relation between unexpected equity returns and earnings news (the shock to expected current and future earnings). Based on this model, we construct a conservatism ratio (CR) defined as the ratio of the current earnings shock to earnings news. CR measures the proportion of the total shock to expected current and future earnings recognized in current year earnings. Ranking firms according to CR, we show empirically that higher CR firms have more leverage, increased volatility of returns, more incidence of losses, more negative accruals, and increased volatility of earnings and accruals, consistent with the literature on conservative accounting.     

Analyst Earnings Forecast Revisions and the Pricing of Accruals

We investigate the relation between two market anomalies to provide insights into analysts role as information intermediaries. Prior research finds that accruals and analyst earnings forecast revisions predict future returns. We find that the accrual and forecast revision strategies generate hedge returns of 15.5% and 5.5% when implemented independently. Strikingly, a combined strategy that uses forecast revisions to refine the accrual strategy generates a hedge return of 28.5%. Firms with consistent accrual and forecast revision signals have less persistent accruals and earnings. We also find that accruals can be used to refine the forecast revision strategy—high accruals are associated with overoptimism in analyst forecasts. Our findings indicate that although forecast revisions reflect information about accrual and earnings persistence beyond that reflected in the level of current year accruals, investors do not fully incorporate this information into their valuation assessments.     

The Accrual Effect on Future Earnings

Earnings manipulation has become a widespread practice for US corporations. However, most studies in the literature focus on whether certain incentives would facilitate managers to manipulate earnings and there has been little evidence documenting the consequences of earnings manipulation. This paper fills this gap by examining how current accruals affect future earnings (the accrual effect) and measuring the size of this effect. We find that the aggregate future earnings will decrease by $0.046 and $0.096, respectively, in the next one and three years for a $1 increase of current accruals. Over the very long-term (25 years), 20% of current accruals will reverse. This negative accrual effect is more significant for firms with high price-earnings ratios, high market-to-book ratios and high accruals where earnings management is more likely to occur. We show that incorporating the accrual effect is useful in improving the accuracy of earnings forecasts for these firms. Accordingly, the empirical results are consistent with the notion that earnings management causes the negative relationship between current accruals and future earnings. In addition, this paper shows that one recently developed accrual model has better performance than the popularly cited model in identifying manipulated earnings.     

Do Analysts and Auditors Use Information in Accruals?

Existing research indicates that firms with high accruals are more likely to experience future earnings problems, but that investors' expectations, as reflected in stock prices, do not appear to anticipate these problems. In this paper, we directly examine the published opinions of two types of professional investor intermediaries to see if they provide investors with information concerning the future earnings problems experienced by firms with high accruals. First, we examine the earnings forecasts of sell-side analysts. We show that analysts' earnings forecasts do not incorporate the predictable future earnings declines associated with high accruals. Second, we examine the behavior of independent auditors. We find no evidence that auditors signal the future earnings problems associated with high accruals through either their audit opinions or through auditor changes. Overall, our evidence indicates that analysts and auditors do not alert investors to the future earnings problems associated with high accruals, thus corroborating previous findings that investors do not appear to anticipate these problems.     

Earnings Quality Measures and Excess Returns

This paper examines how commonly used earnings quality measures fulfill a key objective of financial reporting, i.e., improving decision usefulness for investors. We propose a stock‐price‐based measure for assessing the quality of earnings quality measures. We predict that firms with higher earnings quality will be less mispriced than other firms. Mispricing is measured by the difference of the mean absolute excess returns of portfolios formed on high and low values of a measure. We examine persistence, predictability, two measures of smoothness, abnormal accruals, accruals quality, earnings response coefficient and value relevance. For a large sample of US non‐financial firms over the period 1988–2007, we show that all measures except for smoothness are negatively associated with absolute excess returns, suggesting that smoothness is generally a favorable attribute of earnings. Accruals measures generate the largest spread in absolute excess returns, followed by smoothness and market‐based measures. These results lend support to the widespread use of accruals measures as overall measures of earnings quality in the literature.     

Accruals and the performance of stock returns following external financing activities

This paper investigates the relation of the external financing anomaly with the accrual anomaly, by focusing separately on working capital accruals and long-term accruals. We find that external financing and accrual hedge portfolios not only generate superior returns, but they also constitute statistical arbitrage opportunities. Portfolio-level analysis and firm-level cross-sectional regressions show that the ability of external financing measures in predicting future returns remains strong, after controlling for working capital accruals. However, this ability is substantially reduced after controlling for long-term accruals. Our results appear to be consistent with investors’ failure to recognise agency-related overinvestment and/or opportunistic earnings management.     

Earnings persistence, accruals and managerial share ownership

We investigate the relationship between earnings persistence and a broad measure of total accruals (TACC). We propose and find that in Australia, TACC is less persistent than cash flows. We further propose that the persistence of accrual components is positively associated with the reliability of those components. However, we find that the least reliable accrual component has the greatest persistence and suggest possible reasons for this. We then investigate the relationship between earnings persistence and managerial share ownership, but find no evidence of a consistent, strong relationship. Rather, for the non-current operating accruals we find evidence consistent with incentive alignment for large firms with high operating cash flows, whereas for small firms we find evidence consistent with efficient contracting.     

The accrual anomaly in Europe: The role of accounting distortions

Numerous studies claim that the accrual anomaly in the U.S. stock market is due mostly to temporary accounting distortions arising from accrual accounting. We examine the validity of this explanation in an international setting. Across the 15 developed European equity markets we examine, accounting distortions contribute to the negative relation between accruals and future earnings performance in 14 equity markets. Further, we show that the negative relation between accruals and stock returns could be at least attributable to accounting distortions. In particular, accruals related to accounting distortions predict returns in 7 out of the 9 markets where the accrual anomaly occurs in Europe. Finally, we show that the impact of accounting distortions on the pricing of the accrual component of earnings is stronger in markets with a higher level of trust and a lower level of secrecy.     

Stock performance and the mispricing of accruals

I investigate the relationship between contemporaneous stock-price performance and the persistence of accrued earnings, and its impact on the accrual anomaly. I find that, in a fiscal year, accrued earnings for stocks that have performed poorly are less persistent in predicting future earnings than accrued earnings for stocks that have performed moderately. I further find that a hedge-strategy based on accruals earns greater abnormal returns following bad-news years. The results are consistent with conservative accounting causing accrued earnings to be even less persistent in bad-news years and investors failing to efficiently price this differential in persistence.     

Earnings management of seasoned equity offering firms in Korea

We investigated 249 Korean seasoned equity offering (SEO) firms during the period 1995-1997 to determine if the SEO firms manage earnings in the year before a planned issue of seasoned equity stocks. Using three test methods (accrual difference, correlation, and sign-change), we found that the Korean firms contemplating SEOs in the following year do manage earnings particularly when their relative performances have been poor. The results are robust irrespective of control samples. Analysis of operating performances around SEOs shows that SEO firms tend to increase reported earnings in the year immediately preceding and the year of SEOs, but no differences were found in operating cash flows between the SEO firms and the control firms. By using a regression analysis for discretionary accruals, we found that SEO firms are more likely to manage earnings if the operating performances are poor and if the offer sizes are relatively large. Association tests between stock returns and discretionary accruals indicate that the market reacts positively to net income but negatively to discretionary accruals. The results indicate that the market correctly analyzes the cash flow implications of the SEO firms' opportunistic use of discretionary accruals.     

Investor Sophistication and the Mispricing of Accruals

This paper examines the role of institutional investors in the pricing of accruals. Using Bushee;s (1998) classification of institutional investors, we show that firms with a high level of institutional ownership and a minimum threshold level of active institutional traders have stock prices that more accurately reflect the persistence of accruals. This result holds after controlling for differences in the persistence of accruals between firms with high and low institutional ownership, and after controlling for other characteristics that are correlated with institutional ownership and future returns. Additionally, firms with low institutional ownership are smaller, less profitable, and have lower share turnover, suggesting that limits to arbitrage impede institutional investors from exploiting the seemingly large abnormal returns for these firms.     

High accruals momentum

We examine the information content of high accruals momentum defined as a string of high discretionary accruals for four consecutive years. We find that firms that consistently report high levels of discretionary accruals experience low subsequent returns. The results are robust after we control for annual levels of discretionary accruals for the estimation period of high accruals momentum. Furthermore, the predictive power of the high accruals momentum for future returns is strongly persistent even after the existing accruals anomaly disappears. Our results also show that the high accruals momentum impact is more pronounced for low growth firms, suggesting that the overpricing of stocks with high accruals momentum is driven by managerial discretion to manage earnings.     

Dissecting and connecting the growth and accounting distortion components of accruals

This study refines the accrual decomposition approach in Richardson et al. (Account Rev 81:713–743, 2006) and introduces a growth measure that is free from accounting distortions. My evidence indicates that the lower persistence of accruals extends to accruals that are unrelated to accounting distortions. I, however, find that the growth and accounting distortion components of accruals are not isolated. Growth may provide a context where firms have more incentives to manipulate earnings. I provide evidence that the persistence of both the growth and accounting distortion components of accruals is affected by firm growth and agency cost factors, such as free cash flows, leverage, and overvalued equity. I also document high accounting distortions for relatively high-growth firms that are close to reporting positive earnings, and negative accounting distortions for relatively low-growth firms that are far from the potential to report positive earnings.